27 October 2022
The Environmental Finance Data team answer audience questions from the third quarter 2022 sustainable bond issuance round-up webinar. Compiled by Guy Richardson
Every quarter Environmental Finance hosts a webinar to discuss the EF Data team's latest insights into developments in the labelled bond markets.
Below is a summary of questions submitted by the audience at the most recent event and responses from EF Data.
Q: Could you please clarify the difference between green, sustainability and sustainability-linked bonds?
EF Data: Alongside social bonds, green and sustainability bonds are linked to use-of-proceeds criteria to ensure that funds raised through the issuance are channelled towards suitable green and/or social projects. In most cases these bonds conform to principles and guidelines published by the International Capital Market Association (ICMA), although other sets of principles and alignment types do exist.
Sustainability-linked bonds are significantly different. These are linked to certain pre-agreed key performance indicators (KPIs) and sustainability performance targets (SPTs) relating to environmental, social and governance (ESG) topics including reductions in greenhouse gas emission (overall or scope 1, 2, or 3) or increases in biodiversity, among others. What makes the bond 'sustainability-linked' is that if the issuer fails to meet the SPT, a penalty is triggered – most commonly that the coupon on the bond increases. Conversely, meeting the targets may mean a reward such as reduction in interest rate for the issuer.
Significantly, whereas green, social and sustainability bond labels are usually quite stringent when it comes to use-of-proceeds, sustainability-linked bonds may be issued to fund general corporate purposes.
Q: Can you share any comment on the effect of increased regulation on the volume of issuances of bonds?
EF Data: Regulation is a potential double-edged sword in terms of potential sustainable bond issuance volume trends. Increases in regulation surrounding the bond market could lead to an accompanying increase in issuance as a result of improved standardisation. Yet, the stringent requirements set out in the EU Taxonomy could potentially make the issuance of sustainable bonds and sustainability-linked bonds (SLBs) more complex. Still, the increased sustainability data disclosure requirements will encourage corporates to create data gathering and measuring infrastructure which could then be used to issue sustainable bonds and create accurate KPIs for SLBs. This would put them in a strong position to issue bonds despite potential regulatory hurdles.
Q: What trends are we seeing in impact reports from issuers? Are investors becoming more demanding?
EF Data: We are seeing an overall improvement in the standard of impact reporting among issuers as stakeholders demand increased scrutiny of investments. In addition, investors find themselves under increasing pressure to produce their own impact reports and data for end users such as pension and insurance funds. This trend is likely to lead to improvement across the board amid a push for standardisation in the metrics being chosen for impact reporting. ICMA for example has issued a handbook advising on steps towards harmonisation in impact reporting standards. The push towards more stringent standards in methodologies and standards is likely only to increase.
Q: Are you expecting any large bond issuances in the final quarter
EF Data: There are several sovereigns – such as New Zealand – that have expressed their interest in issuing additional bonds that could potentially be quite large. There is also some evidence that sustainable bond issuance – both large and small – that was paused earlier in the year amid the fixed income market turmoil may now be returning to the market as we approach the end of the year. Despite this, it remains uncertain whether total 2022 volume of issuance will exceed $1 trillion in the final quarter. Indeed, some experts now believe the sustainable bond market will struggle to surpass the $1 trillion annual record set in 2021 – perhaps even shrinking for the first time since 2011.
Q: Do you see conventional energy (oil and gas firms) issuing more sustainable bond instruments?
EF Data: We are seeing more bonds issued by conventional energy firms and related entities coming on to the market, with 22 oil and gas sector issuers in 2022 alone, including PetroChina's CNY2 billion green bond in June. Organisations specifically involved in oil and gas extraction and production are increasingly less likely to issue transition bonds, as these have attracted controversy in the past. On the other hand, there is certainly scope for these entities to issue SLBs in greater numbers, although we expect companies in the oil and gas industry to be most likely to choose to issue use-of-proceeds labelled bonds to fund specific projects with a sustainability focus. We see that sustainable bonds issued by conventional energy firms continue to be popular despite bonds issued by the oil and gas sector often being outright excluded as part of some investment strategies. There are sustainable investors in the market with a mandate to fund the transition of the highest emitting sectors, including oil and gas.
Q: Could the US Inflation Reduction Act have a transformative effect on the labelled bond market?
EF Data: We have seen increased activity among US municipal bond issuers in Q3 - total issuance topped $23 billion - although it remains to be seen whether the same effect will be felt in the US corporate bond market more broadly. It is also unclear whether the US Inflation Reduction Act has been a driver of this rising interest or is just the result of the growing sustainable finance momentum in the US.
Q: Any estimates gathered for Q1 2023 sustainable bond issuance volumes (globally)?
EF Data: Volatility in the market – including rising interest rates and inflation – mean that we do not expect to see the same levels of growth in the sustainable bond market as we saw in the first half of, say, 2021 when the market experienced particularly high issuance volume.
Year-on-year quarterly analysis points to a strengthening of sustainable bond issuance, however, with Q3 2022 only contracting 13% from Q3 2021 — a much stronger relative performance than the 21% and 15% year-on-year declines in Q1 and Q2 2022, respectively. This momentum could be carried into 2023 with a stronger Q1 than 2022.
There is some speculation that the sustainable bond market could experience a decoupling from the wider bond market, with 'vanilla' bonds and sustainable bonds performing differently. So far, sustainable and 'vanilla' bonds have tended to experience similar performance although this could change in future amid challenging economic conditions and depressed overall issuance. Alongside the reputational advantages of issuing a sustainable bond, the reported persistence of the 'greenium' – or pricing perk from issuing 'green' debt – affecting sustainable bond issuance could make these instruments increasingly attractive in this challenging fixed income environment.
Q: How do you see growth of SLBs in 2023? What type of issuer do they most appeal to?
EF Data: SLB issuance slowed slightly in Q3 2022 against a backdrop of rising interest rates, inflation, and geopolitical tensions depressing fixed income markets.
This may also be linked to several high-profile cases where issuers have fallen behind on meeting their SLB SPTs and have encountered controversy as a result. For example, this quarter, Chanel narrowly failed to meet interim targets on their SLB – though not yet impacting their pricing trigger targets. These factors may be causing issuers in some cases to re-evaluate the suitability of SLBs for their business.
Nonetheless it's worth noting that when it comes to KPIs, truly ambitious targets are always at risk of not being met. Ambitious targets occasionally not being fulfilled may be preferable to an environment where issuers are deterred from setting genuinely ambitious targets for fear of the fallout that may accompany failure to meet them. A possible solution could be the expansion of step-up/step-down interest rate pricing on SLBs to emphasise the rewards of meeting and exceeding targets as much as the penalties for failing to do so, a practice more common in the sustainability-linked loan market.
SLBs continue to appeal predominantly to corporate issuers, with more than $9 in every $10 raised through SLBs to date being by corporates. This has to do with the fact that these issuers often wish to improve their sustainability profile across their operations but may not be involved in projects of an appropriate size that have an explicit environmental or social focus that meets the stringent criteria of the green, social and sustainability labels.
Still, the widespread gathering of data relating to sustainability performance by sovereigns puts them in a strong position to benefit from SLBs and we may therefore see an uptick in the number of sovereign issuers in the near future. Financial issuers, meanwhile, often struggle due to regulatory challenges – but some cases have occurred.
Q: Will SLBs be likely to come from emerging markets?
EF Data: Emerging market (EM) issuers (as defined by the MSCI index) have issued 62 SLBs with a total value of $32 billion. This figure includes the first ever sovereign SLB issued by Chile in March 2022, and is led by Brazilian issuers who have embraced the SLB format, with 15 issued since 2020 at a total value of $9.7 billion.
Still, there exist some barriers to SLBs in EMs, such as the lack of data gathering mechanisms in those markets that are often needed to report against KPIs. Due to liquidity constraints in EMs, other debt products such as loans may often suit the needs of potential issuers better than fixed income options.
Eligible sustainable project pipelines can be a challenge for potential EM issuers which makes the structure of an SLB, with the less stringent use of proceeds requirements, an attractive option.
Q: Could you give your perspective on Uruguay's recent SLB framework – especially their combination of step-up and step-down mechanisms?
EF Data: Although other issuers – such as seafood firm Thai Union – have incorporated both step-up and step-down provisions in the past, Uruguay is the first sovereign to do so. Further, it is only the second sovereign ever to have issued an SLB following Chile's SLB debut in March 2021.
Notably, Uruguay's SLB framework incorporates both step-up and step-down provisions depending on whether the country meets or misses its SPTs relating to greenhouse gas emissions intensity in the country's goods and services industry and the preservation of Uruguay's native forests. In turn, these objectives are derived from 2025 goals set out as part of Uruguay's Nationally Determined Contributions as part of the Paris Climate Agreement.
The targets set out in Uruguay's framework, including a 50% reduction of greenhouse gas emissions per unit of GDP, are notable for their ambition. All metrics in the framework were rated ambitious by the sovereign's second party opinion providers with one – a 3% increase in native forests – judged "highly ambitious".
Q: How do you see the 25 basis points step-up 'pattern' for SLBs? What should drive the level of step-ups?
EF Data: Recently, the 25 basis points (bps) step-up/step-down pattern has emerged as a kind of unofficial market consensus in the way bonds are priced. However, in some quarters there is a perception that 25bps is too lenient and is not sufficient to disincentivise poor performance. That said, perhaps of greater significance is the reputational damage that can arise from not achieving sustainability targets. There could be increases in the step-up/step-down rate in future transactions, although it is far from clear whether this will be the real carrot or stick to actually get companies to meet their targets.
In the current higher interest rate environment, that 25bps (dis)incentive has become even less material.
The full Q3 bond round-up webinar can be viewed for free here.